Some diagnoses can be ruled out. The Marxist theory of economic cycles with its declining rate of profit is clearly useless; businesses were making record profits on the eve of the bust. There was no shock to Total Factor Productivity which a Real Business Cycle explanation would require. Keynesian ‘animal spirits’ are also unsatisfactory. The flight from mortgage backed assets was a totally rational response to the Federal Reserve raising interest rates between 2004 and 2007.

But there is another diagnosis which fits the symptoms quite well; Austrian Business Cycle Theory (ABCT), so called because it grows out of the Austrian School of economics founded in Vienna by Carl Menger in the nineteenth century. It describes the causes and course of the current crisis better than any other theory and offers some insights in to what lies ahead.

ABCT starts with the idea that the interest rate is a price like any other matching the supply of something to the demand for it. Funds for investment are supplied (via saving); savings are demanded (for investment). If people cut back on current consumption and save more to increase future consumption then the interest rate falls and firms are able to borrow more to invest in the means to supply that future consumption. And when people begin drawing down their savings to fund current consumption the interest rate rises and firms cut back on investing for future consumption.

The key insight is that the interest rate is a real phenomenon. As the Austrian School economist Eugen von Böhm-Bawerk put it, it reflects the ‘time preference’ of economic agents, the value they place on consumption of something now compared to the value they place on consumption of the same thing at some given point in the future. The interest rate reflects the compensation/incentive for abstinence on the part of the saver.

But in the real world we have central banks. In response to something like the bursting of the dot com bubble the Federal Reserve can lower interest rates, as it did in that instance, from 6.25% to 1.75% over the course of 2001.

However, the interest rate is not falling because of increased saving (or decreasing time preference), rather it is being forced down artificially by the expansion of credit; the creation of phony capital in other words.

As interest rates fall firms see ever more marginal investment opportunities becoming profitable. They borrow and undertake them. A boom is underway.

But eventually the inflation caused by this credit expansion starts to show even in the central bank’s cooked figures as when inflation went above 4% in the US in 2006. Interest rates are raised; the Fed Funds rate went above 5% the same year. Those marginal investments that looked viable at 1% are now scuppered.

This is the bust. All the enterprises undertaken in the expectation of catering for the demand for future consumption indicated by low interest rates discover that there is, in fact, no such demand. There never was. They are revealed as ‘malinvestments’, with no hope of ever producing a return above their borrowing costs unless interest rates are kept artificially low and cheap credit is kept flowing.

The recession is not some mysterious collapse in aggregate demand which can be stopped with a dose of government spending. It is the liquidation of these unviable credit positions and it will not be over until this process is complete.

The Austrian School economist Ludwig von Mises wrote

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved

This is the Austrian choice; recognize the liquidation and allow zombie banks to collapse and stop soaking up scarce capital so we can get the recovery going or keep putting it off with more monetary and fiscal stimulus. And, as another Austrian Schooler, Friedrich von Hayek, warned,

The magnitude of unemployment caused by a cessation of inflation will increase with the length of the period during which such policies are pursued

True, this is a grim prospect, but that matters less than whether it’s correct. Anyone who says there is a third option, a painless way out which can be found simply by ticking a different box on a ballot paper, truly is peddling snake oil.

5 comments to As easy as ABCT

I’m not sure about the claim that central banks can or do lower interest rates. You could equally well argue that interest rates are artificially HIGH and on the grounds that the government / central bank machine is a NET BORROWER. And a borrower to some tune: the national debt of most countries is at least 50% GDP and in some cases well over 100%.

Of course central banks can TINKER with interest rates, but my point is that the net and overwhelming effect of governments and central banks is to RAISE interest rates.

I agree with John Phelan that there is such a thing as “phony capital”. But I suggest the source of this is the fractional reserve banking system. That is, the private sector bank system can create money or “savings” out of thin air.

The important thing to note is that there is a ‘real’ rate of interest which reflects people’s time preferences and what Wicksell called a ‘money’ rate of interest. A central bank can force these apart either way by pushing the money rate of interest above or below the market rate.

ABCT starts with the idea that the interest rate is a price like any other matching the supply of something to the demand for it. Funds for investment are supplied (via saving); savings are demanded (for investment). If people cut back on current consumption and save more to increase future consumption then the interest rate falls and firms are able to borrow more to invest in the means to supply that future consumption. And when people begin drawing down their savings to fund current consumption the interest rate rises and firms cut back on investing for future consumption.

Surely this is a very flawed starting point for a theory and given the often excellent comentary on the problems with fractional reserve bank provided by TCC I have to ask; do Austrians still base their business cycle theory on this very obviously non-empirical idea of how banks and for that matter consumers go about their business?

” That is, the private sector bank system can create money or “savings” out of thin air.”

Of course, it can. And when the central bank creates several billions more in reserve for its members to borrow lowering its interest rates to entice them to borrow them], they can create even more money or “savings” out of thin air.

I don’t understand your claim that the central bank cannot or does not do what it does.